Cutting the Federal Budget

Hauser's Law tells us that whatever the tax structure, the federal government can't collect more than 19% of GDP in taxes on a sustained basis -- meaning that either taxpayers will find loopholes to avoid taxes or that the disincentives of higher tax rates will result in lower tax payments and/or lower overall economic growth.Estimated spending for fiscal year 2011 looks like this:

% of GDP

Social Security

$ 750 billion

5.0%

Medicare

$ 500 billion

3.3%

Medicaid

$ 400 billion

2.6%

Unemployment

$ 625 billion

4.1%

Defense

$ 775 billion

5.1%

Other

$ 525 billion

3.5%

International Affairs

$ 50 billion

0.4%

Interest

$ 200 billion

1.4%

Total

$3,825 billion

25.4%

Let's take this as the limit for the federal budget on an ongoing basis. In round numbers, we have to get spending back down to 19% of GDP from its current level of 25.4% of GDP. There is no easy way to do this. The interest on the federal debt is very favorable just now. Gross federal debt is estimated to be $15 trillion at the end of this fiscal year. Net debt is estimated to be $11 trillion. If we key off the net debt (essentially, the difference between the two numbers is the debt held by the various federal trust funds), then the $200 billion net interest expense shown in the table is a pretty attractive interest rate of 1.8%! It could easily triple should (a) there be a surge in inflation from the huge quantitative easings of the Fed, or (b) a run on the dollar which would require a spike in interest rates to stop. So, in terms of interest payments on the national debt, we are now in a perfect world and/or a fool's paradise. Tax receipts by the federal government from all sources as a percentage of GDP are shown in the following chart:

The dotted line is at 19%. Federal tax receipts -- including those from Social Security -- have been in the range of 16% - 19% of GDP with some excursions above and below that level since 1960. The orange vertical line is at 2008, the last year of the Bush (43) Administration. For the past three years, the first three years of the Obama Administration, tax receipts have been below the bottom end of the range, reflecting the severity of the recession and the very slow recovery from it.

We can add federal expenditures as a percentage of GDP to this chart:

The deficit in any given year is the difference between expenditures in the red line and receipts in the blue line. The surge in spending and the loss of tax revenues in the last three years show up clearly. Where are we going? We have a ruinous deficit now, which shows up as the howling gap between expenditures and revenues in the chart above. Part of this is due to the recession, but a lot of it isn't. What to do? The only thing we can do if we value the future of the Republic is to bring the federal budget back into balance.

% of GDP

$

% of GDP

Social Security

$ 750 billion

5.0%

$250

1.6%

Medicare

$ 500 billion

3.3%

$175

1.2%

Medicaid

$ 400 billion

2.6%

$125

0.9%

Unemployment

$ 625 billion

4.1%

$200

1.3%

Defense

$ 775 billion

5.1%

$ 25

0.2%

Other

$ 525 billion

3.5%

$150

1.0%

International Affairs

$ 50 billion

0.4%

Interest

$ 200 billion

1.4%

Total

$3,825 billion

25.4%

$925

6.2%

The table above shows that current expenditures are running this year at 25.4% of GDP. But the federal government cannot expect to collect more than 19% of GDP in revenues and still have a healthy growing economy. If we believe this, then we have to reduce expenditures by 6.4 percentage points. Let's see how this might be done.

Possible spending cuts

This analysis will be crude because we don't have the granularity of information they presumably have in Washington, but it can be a useful exercise nevertheless. Here is the same table that is at the beginning of this essay but with an additional two columns for our spending reductions, expressed both in dollars and as a percentage of GDP.

We'll start in the middle of the table and then go back to entitlements at the top of the table.

Unemployment - About $200 billion has been added to the income security account during the recession. There may be trending aspects to this account that will result in ever-higher expenditures, but I am assuming that we get a "dividend" from employment improvement in a growing economy and that we can get that $200 billion back. The $200 billion is listed in the "reductions" column. It is 1.3% of GDP.

Defense - We are making only a small cut in Defense of $25 billion, or 0.2% of GDP, given the threats we face, particularly from radical Islam.

Other - This is "the rest of the government" -- essentially everything we think of as government except for the military. There are approximately 2.2 million civilian federal employees. If we assume that the cost per employee is roughly $110,000, then this comes out to a total bill of approximately $250 billion per year. Let's say that everybody has to sacrifice, particularly since the mission of the government is to deliver services, and it can deliver more services if the cost of doing so is reduced. So, let's take a 10% cut in compensation for federal civilian employees. This is $25 billion.

We can cut some deadwood from the government. It's pretty clear that since we have had an Education Department the performance of American public education has deteriorated. Let's eliminate this department entirely. According to the budget, it spends $64 billion.

Let's also eliminate the Energy Department net of its nuclear activities. This saves $17 billion.

These may seem extreme moves, but remember the context -- our lifeboat is sinking. Without changes, the country faces financial ruin. Now is the time to get rid of extravagances.

If we eliminate Housing and Urban Development, we save another $43 billion, bringing our total to $25 + $64 + $17 + $43 = $149 billion. Let's round this off to $150 billion.

There is some double counting here because we have gained $25 billion from a cut in federal employee compensation, and here we are eliminating some employees. But this is a crude estimating process and we will just accept some imprecision.

I am not sure what International Affairs consists of and am therefore leaving that unchanged. So, in this section, we have made cuts to Unemployment, Defense, and Other in the amount of $375 billion, or 2.5% of GDP. Our goal is to reduce spending by $975 billion, or 6.4% of GDP. We have $600 billion or 3.9% of GDP to go.

Entitlements

Entitlement spending for 2011 as shown in the top three categories in the table is $1,650 billion. To get spending down to the 19% of GDP we are seeking, we need a contribution from entitlements of $600 billion. That is, we need to cut entitlements by 36%. Let's simplify this and say that we need to cut entitlements by one-third.

For simplicity, let's say that we are going to cut each of the programs by the same proportion. Medicaid has perhaps the neediest constituency, so we may need to adjust that assumption, but let's start with one-third each.

Social Security - Let's assume that the average benefit is $15,000 per year. There is also disability mixed in with Social Security, but let's ignore that for now. If the average benefit is $15,000, then this year, Social Security is paying out to 50 million people. Let's assume we don't want to reduce the benefit. Can we cut one-third, or 16.5 million people from the Social Security rolls? We would need a thorough breakdown of Social Security beneficiaries and their pensions and other incomes.

One-third of Social Security is about $250 billion, or 1.7% of GDP.

Medicare - We need to know exactly what Medicare is spent on. For instance, a breakdown might go this way:

This data will point the way to where savings might be achieved. For instance, "procedures" might be put out for competitive bid. It may be that Medicare should only be a catastrophic care benefit, with "ordinary care" taken care of by the patient or by Medicaid. Means-testing would again be a part of the approach.

One-third of Medicare expenses is about $175 billion, or 1.2% of GDP.

Medicaid - Medicaid breaks down into two parts: (1) the safety net for citizens who don't have insurance and can't afford medical care; (2) old-age nursing home care, which can be quite prolonged.

On the second part, the citizenry has developed the understanding that there is merit in making seniors in the family financially destitute, since they can then get nursing home care paid for by the state, with the level of care in no way different from what it is for those paying privately.

It might make sense for those turning 65 to have to account for their assets and not to be able to transfer some amount of assets out until death, so that a greater part of the senior's assets are secured to pay for old-age care. We are talking about bankrupting the country here, so if there is a time for extreme measures, this is it.

One-third of Medicaid expenses is about $125 billion, or 0.9% of GDP.

Conclusion

In this exercise, we have saved $925 billion, or 6.2% off of 2011's budget and brought spending down to $2,900 billion, or 19.2% of GDP. Note that with all the rapine and pillage implied by these cuts, we have "only" cut the $1,645 billion deficit for 2011 by $925 billion to $720 billion. To net out the deficit entirely, we would have to bring tax receipts up to 19% of GDP, whereas they are expected to be 14.4% of GDP for 2011.

Hauser's Law tells us that whatever the tax structure, the federal government can't collect more than 19% of GDP in taxes on a sustained basis -- meaning that either taxpayers will find loopholes to avoid taxes or that the disincentives of higher tax rates will result in lower tax payments and/or lower overall economic growth.Estimated spending for fiscal year 2011 looks like this:

% of GDP

Social Security

$ 750 billion

5.0%

Medicare

$ 500 billion

3.3%

Medicaid

$ 400 billion

2.6%

Unemployment

$ 625 billion

4.1%

Defense

$ 775 billion

5.1%

Other

$ 525 billion

3.5%

International Affairs

$ 50 billion

0.4%

Interest

$ 200 billion

1.4%

Total

$3,825 billion

25.4%

Let's take this as the limit for the federal budget on an ongoing basis. In round numbers, we have to get spending back down to 19% of GDP from its current level of 25.4% of GDP. There is no easy way to do this. The interest on the federal debt is very favorable just now. Gross federal debt is estimated to be $15 trillion at the end of this fiscal year. Net debt is estimated to be $11 trillion. If we key off the net debt (essentially, the difference between the two numbers is the debt held by the various federal trust funds), then the $200 billion net interest expense shown in the table is a pretty attractive interest rate of 1.8%! It could easily triple should (a) there be a surge in inflation from the huge quantitative easings of the Fed, or (b) a run on the dollar which would require a spike in interest rates to stop. So, in terms of interest payments on the national debt, we are now in a perfect world and/or a fool's paradise. Tax receipts by the federal government from all sources as a percentage of GDP are shown in the following chart:

The dotted line is at 19%. Federal tax receipts -- including those from Social Security -- have been in the range of 16% - 19% of GDP with some excursions above and below that level since 1960. The orange vertical line is at 2008, the last year of the Bush (43) Administration. For the past three years, the first three years of the Obama Administration, tax receipts have been below the bottom end of the range, reflecting the severity of the recession and the very slow recovery from it.

We can add federal expenditures as a percentage of GDP to this chart:

The deficit in any given year is the difference between expenditures in the red line and receipts in the blue line. The surge in spending and the loss of tax revenues in the last three years show up clearly. Where are we going? We have a ruinous deficit now, which shows up as the howling gap between expenditures and revenues in the chart above. Part of this is due to the recession, but a lot of it isn't. What to do? The only thing we can do if we value the future of the Republic is to bring the federal budget back into balance.

% of GDP

$

% of GDP

Social Security

$ 750 billion

5.0%

$250

1.6%

Medicare

$ 500 billion

3.3%

$175

1.2%

Medicaid

$ 400 billion

2.6%

$125

0.9%

Unemployment

$ 625 billion

4.1%

$200

1.3%

Defense

$ 775 billion

5.1%

$ 25

0.2%

Other

$ 525 billion

3.5%

$150

1.0%

International Affairs

$ 50 billion

0.4%

Interest

$ 200 billion

1.4%

Total

$3,825 billion

25.4%

$925

6.2%

The table above shows that current expenditures are running this year at 25.4% of GDP. But the federal government cannot expect to collect more than 19% of GDP in revenues and still have a healthy growing economy. If we believe this, then we have to reduce expenditures by 6.4 percentage points. Let's see how this might be done.

Possible spending cuts

This analysis will be crude because we don't have the granularity of information they presumably have in Washington, but it can be a useful exercise nevertheless. Here is the same table that is at the beginning of this essay but with an additional two columns for our spending reductions, expressed both in dollars and as a percentage of GDP.

We'll start in the middle of the table and then go back to entitlements at the top of the table.

Unemployment - About $200 billion has been added to the income security account during the recession. There may be trending aspects to this account that will result in ever-higher expenditures, but I am assuming that we get a "dividend" from employment improvement in a growing economy and that we can get that $200 billion back. The $200 billion is listed in the "reductions" column. It is 1.3% of GDP.

Defense - We are making only a small cut in Defense of $25 billion, or 0.2% of GDP, given the threats we face, particularly from radical Islam.

Other - This is "the rest of the government" -- essentially everything we think of as government except for the military. There are approximately 2.2 million civilian federal employees. If we assume that the cost per employee is roughly $110,000, then this comes out to a total bill of approximately $250 billion per year. Let's say that everybody has to sacrifice, particularly since the mission of the government is to deliver services, and it can deliver more services if the cost of doing so is reduced. So, let's take a 10% cut in compensation for federal civilian employees. This is $25 billion.

We can cut some deadwood from the government. It's pretty clear that since we have had an Education Department the performance of American public education has deteriorated. Let's eliminate this department entirely. According to the budget, it spends $64 billion.

Let's also eliminate the Energy Department net of its nuclear activities. This saves $17 billion.

These may seem extreme moves, but remember the context -- our lifeboat is sinking. Without changes, the country faces financial ruin. Now is the time to get rid of extravagances.

If we eliminate Housing and Urban Development, we save another $43 billion, bringing our total to $25 + $64 + $17 + $43 = $149 billion. Let's round this off to $150 billion.

There is some double counting here because we have gained $25 billion from a cut in federal employee compensation, and here we are eliminating some employees. But this is a crude estimating process and we will just accept some imprecision.

I am not sure what International Affairs consists of and am therefore leaving that unchanged. So, in this section, we have made cuts to Unemployment, Defense, and Other in the amount of $375 billion, or 2.5% of GDP. Our goal is to reduce spending by $975 billion, or 6.4% of GDP. We have $600 billion or 3.9% of GDP to go.

Entitlements

Entitlement spending for 2011 as shown in the top three categories in the table is $1,650 billion. To get spending down to the 19% of GDP we are seeking, we need a contribution from entitlements of $600 billion. That is, we need to cut entitlements by 36%. Let's simplify this and say that we need to cut entitlements by one-third.

For simplicity, let's say that we are going to cut each of the programs by the same proportion. Medicaid has perhaps the neediest constituency, so we may need to adjust that assumption, but let's start with one-third each.

Social Security - Let's assume that the average benefit is $15,000 per year. There is also disability mixed in with Social Security, but let's ignore that for now. If the average benefit is $15,000, then this year, Social Security is paying out to 50 million people. Let's assume we don't want to reduce the benefit. Can we cut one-third, or 16.5 million people from the Social Security rolls? We would need a thorough breakdown of Social Security beneficiaries and their pensions and other incomes.

One-third of Social Security is about $250 billion, or 1.7% of GDP.

Medicare - We need to know exactly what Medicare is spent on. For instance, a breakdown might go this way:

This data will point the way to where savings might be achieved. For instance, "procedures" might be put out for competitive bid. It may be that Medicare should only be a catastrophic care benefit, with "ordinary care" taken care of by the patient or by Medicaid. Means-testing would again be a part of the approach.

One-third of Medicare expenses is about $175 billion, or 1.2% of GDP.

Medicaid - Medicaid breaks down into two parts: (1) the safety net for citizens who don't have insurance and can't afford medical care; (2) old-age nursing home care, which can be quite prolonged.

On the second part, the citizenry has developed the understanding that there is merit in making seniors in the family financially destitute, since they can then get nursing home care paid for by the state, with the level of care in no way different from what it is for those paying privately.

It might make sense for those turning 65 to have to account for their assets and not to be able to transfer some amount of assets out until death, so that a greater part of the senior's assets are secured to pay for old-age care. We are talking about bankrupting the country here, so if there is a time for extreme measures, this is it.

One-third of Medicaid expenses is about $125 billion, or 0.9% of GDP.

Conclusion

In this exercise, we have saved $925 billion, or 6.2% off of 2011's budget and brought spending down to $2,900 billion, or 19.2% of GDP. Note that with all the rapine and pillage implied by these cuts, we have "only" cut the $1,645 billion deficit for 2011 by $925 billion to $720 billion. To net out the deficit entirely, we would have to bring tax receipts up to 19% of GDP, whereas they are expected to be 14.4% of GDP for 2011.